How Do Bonds Work?

A friend of mine moved her 401K stocks into bonds at the end of last year because she thought a revolution was coming. While that assumption was not completely out of the realm of possibility, she unfortunately missed the market runup of the last year. Any good financial advisor will tell you not to try to time the market and I get that, but one should at least know what is going on. And to do that, you need to know how bonds work and how they relate to stocks. To her credit, my friend called to ask me how bonds work.

Let’s start with a bit of basic housekeeping:

Bond yields have a negative relationship with bond prices.

Bond yields have a positive relationship with the stock market.

Easy peasy. But many people, even investors don’t understand why. Before I get to that, I’ll explain what a bond is.

Buying a Bond

Buying a bond is like loaning someone money. You pay them for the bond, called the “price,” and they promise to pay you back. It’s an IOU. If you buy a 10-year bond, they have to pay you back in full in ten years. In the meantime, they pay you interest. That is your payment for letting them have your money for ten years. That’s called the “yield” on a bond.

If it’s a Treasury Bond, the U.S. Government is the borrower. They use the money you loan them to do all the things that the U.S. Government does. They build bridges and buy missiles and give out stimulus checks, and pay salaries for bureaucrats and pay for interest on all their other bonds and stuff like that.

While there are different lengths of time you can buy, I’ll talk about the ten-year bond here. That’s the one that mortgage rates are based on. With a ten-year bond, the government has ten years to pay you back. In return you get the going interest rate (yield) on the money you loaned them. Right now, that’s 1.528%. Not very much when you’re paying 18% or more for your credit cards, but it’s guaranteed by the U.S. Government and better than putting your money under a mattress or a savings account for that matter.

Secondary Market

Because sometimes people can’t tie up their money for ten years, or they change their minds and want to buy a Porsche, there is a secondary market for bonds. You can sell them to other people before the ten years are up. Here’s the important part – the yield of your bond does not change. In my example, it is 1.5% locked in for ten years.

Let’s say that a couple months from now after you have picked out your Miami Blue Porsche 911, the interest rates go up and you can buy a 10-year bond with a 2% yield. The yield went up from 1.5% to 2%. That is worth more money, correct? Whoever buys that 2% bond is making more money than you are now. So the price that you sell your bond to another person goes down. Why? Because instead of buying a 10-year bond from you that pays 1.5%, they can buy a new ten year bond and make 2%. Conversely, if the yield on a new bond goes down to 1.3%, the price or value of your bond will go up, because your bond pays a higher yield at 1.5%.

That’s the logic behind why the yield and the price of a bond have an inverse relationship. It’s all about timing.

There’s a formula on how to calculate the price of your bond. As of today, the yield of 1.5% You don’t have to know this because these prices are figured out and published. But here it is in case you want to know:

Bond Price = ∑(Cn / (1+YTM)^n )+ P / (1+i)^n

• n = Period which takes values from 0 to the nth period till the cash flows ending period
• Cn = Coupon payment in the nth period
• YTM = interest rate or required yield
• P = Par Value of the bond

So if you bought your bond yesterday and wanted to sell it today, your price would have gone down by .082%. Again, this price is published and easy to look up so you don’t have to possess mad math skills.

How Bonds Relate to the Stock Market

Bonds have a relationship to the stock market as well. When the yields on bonds go down (and their prices go up), the stock market usually goes down. Why? Logically it is because bonds compete with stocks for investors’ dollars. When the stock market is booming, people will put their money into stocks and take it out of bonds, so the value of bonds goes down. And when the value of bonds goes down, (from oversupply), the price goes down and the yields increase because as mentioned above and shown in the formula, the yields and prices of bonds always move in a pre-determined inverse relationship.

There are a lot of psychological reasons why stocks go up and down. Generally, economists believe in the rational man theory which states that people will act rationally. If a company loses money, their stocks should go down, and it follows that people won’t buy that stock or if they already own it, they may sell it. But there are many other factors involved including people’s view of the future potential of a company or its products. Stocks are dependent on the psychology of individuals, companies and society. But at least you now know how bonds work, and how bonds work in relation to the stock market.

Disclaimer: All information found here, including any ideas, opinions, views, predictions, forecasts, commentaries, suggestions, or stock picks, expressed or implied herein, are for informational, entertainment or educational purposes only and should not be construed as personal investment advice.